The UK Government has issued a consultation paper setting out proposals for UK tax deductions for interest paid on both third party and related party debt to be capped. This represents a fundamental change to the UK taxation of debt with a potentially significant impact on UK leveraged renewable projects.
Why is this important?
Tax deductions for interest paid on third party debt and related party debt have significant value and can materially improve the potential returns from projects by reducing the amount of tax payable on income generated by a project.
For infrastructure projects such as the development of renewable sites, tax deductibility for interest is even more important as the viability of third party project finance is often dependent upon such tax deductions.
Historically and currently, no restrictions have applied to UK tax deductions for interest payable on third party debt. Related party debt has been subject to certain restrictions, although these have largely applied on transaction by transaction where the terms are not on an arm’s length basis.
What are the proposed changes?
Broadly, the consultation paper proposes a cap on the amount of interest expense of a company or group that is deductible for UK tax purposes.
The proposals are at a very early stage and the details have not yet been determined, but the basic outline of the cap is as follows:
- interest deductions for UK businesses will be capped at a fixed percentage of EBITDA;
- the fixed percentage (or ratio) has not been determined, but will be between 10-30%;
- the cap will apply to interest and interest-like payments, as well as associated finance expenses.
To give a very simple example of the impact of the proposed change, assume £60m of third party financing is taken to construct a renewable energy project. The annual interest rate payable on this loan is 7%. Once constructed, income from the project will give the company an EBITDA of £5m.
Under the current rules, £4.2m of interest p.a. would be payable on the financing which would be fully deductible for UK tax purposes, reducing the tax payable on the income generated by £840k. If, say, the interest cap was set at 20% of EBITDA, this would cap the company’s interest deductions at £1m, resulting in a tax reduction of only £200k. The after-tax profit of the company would be reduced by £640k.
Why is this happening?
As part of the OECD’s Base Erosion and Profit Shifting (BEPS) project, recommendations have been made by the OECD for countries to introduce interest capping rules to restrict BEPS. As a lead member of the OECD and active participant in the BEPS project, the UK has been quick to adopt OECD recommendations as they are announced. The consultation issued on 22 October 2015 (link below) represents the UK Government’s first steps to comply with the OECD recommendations on interest capping.
When will this cap be introduced?
It will take time to determine the final details of the proposed cap. The consultation states that the cap will not be introduced before 1 April 2017.
Will there be any grandfathering for existing debt?
This is an issue on which the Government are consulting, but the consultation paper indicates a preference for there to be no grandfathering.
If this is the case, these rules will apply to debt obligations committed to before the cap is introduced. This could have a very material impact on the economics of many current renewable projects, particularly where the financial modelling has assumed the availability of interest deductions.
However, note the proposed Public-Benefit Project exemption discussed below.
Will there be any exemptions or limitations?
The following exemptions and limitations are being consulted on:
- a de minimis interest deduction threshold (a threshold of £1m is discussed);
- an exemption for small and medium-sized entities;
- a worldwide group ratio upper limit to allow for groups that require higher levels of external gearing;
- carry back and carry forward capability for interest deductions exceeding the cap;
- an exemption for qualifying large scale, highly-geared infrastructure projects (known as Public-Benefit Projects);
- alternative rules for the banking and insurance sector.
Whether these exemptions/limitations will be included in the final provisions and the details of such exemptions/limitations is still unknown. It will be a key part of the public consultation process for business to engage with the Government to ensure practical and workable exemptions/limitations are implemented.
What is the Public-Benefit Projects exemption?
For renewables projects, the scope and application of this exemption will be very important.
The OECD recognised in its recommendations that certain large scale, highly-geared infrastructure projects that provide a public benefit should be excluded from the interest capping rules. The UK Government appears to support such an exclusion and wants to consult with business on the design of this exclusion.
The consultation paper indicates that the design should reflect the OECD recommendations, which provide that the exclusion should be limited to the following types of project:
- the provision and operation of assets on a long-term (10yrs+) basis where restrictions apply to the operators ability to dispose of the assets;
- the operator is obliged to provide the relevant goods/services for the general public interest by a public sector body/public benefit entity;
- the project finance is provided on a non-recourse basis;
- the project finance does not exceed the value of the assets acquired/constructed;
- the project operator, the interest expense, the project assets and the income from the project all arise in the same country.
For renewable projects providers, this will be the area that is likely to require the most active engagement with Government to design a workable exemption.
It is not clear whether for example a public benefit exemption is expected to be applicable to power projects involving distributed/onsite generation, where the primary offtaker of power is a private company, but where excess power generated from the project can be re-distributed onto the grid. This could potentially be an important point for those engaged in the distributed generation market, and they should consider direct engagement in the consultation process if their business model includes an element of third party financing to deliver their projects.
The introduction of a cap on interest deductions represents a fundamental change to the UK taxation system which will have a significant impact on all businesses operating in the UK. For the renewables sector, this impact could be particularly strongly felt.
The Government clearly wants to engage closely with business to formulate the details of the rules and several rounds of consultation are anticipated. Consequently, businesses should be actively considering the potential impact of these rules and, if relevant, should engage with the Government to shape the detail of the rules. Examples of how the rules could impact real businesses will be powerful at the time when the Government is willing to listen (i.e. now) and could drive material change and concessions.
The deadline for responses to the current consultation is 14 January 2016.